Hussman - The Other Side of the Mountain

Weekly Market Comment
April 7, 2014
by John P. Hussman, Ph.D.

Excerpts:

The financial markets are at a transition that reflects tension between two realities. The first is that the Federal Reserve’s policy of quantitative easing has driven the stock market to valuations associated with the most extreme speculative peaks on record, coupled with a fresh boom in initial public offerings – with companies having zero or negative earnings accounting for three-quarters of new issuance – and record issuance of “covenant lite” leveraged loans (loans to already highly indebted borrowers, lacking normal protections that mitigate losses in the event of default). The other reality is that unconventional monetary policy has done little to push real economic activity or employment past the border that has historically distinguished expansions from recessions (about 1.8% year-over-year growth in both real final sales and non-farm payroll employment).

There is no question that quantitative easing has supported the mortgage market, and was almost wholly responsible for that role in late-2008 and 2009. But QE is not what ended the financial crisis (the March 2009 change in accounting rule FAS 157 is what removed the risk of widespread bank failures). Any economist familiar with the work of Nobel laureates like Milton Friedman or Franco Modigliani, or simply with decades of economic data, could have predicted even in 2010 that Bernanke’s efforts at creating a “wealth effect” would have weak effects on consumption, job creation and economic activity. In order to get any meaningful overall effect, it was clear that the Fed would have to create enormous but ultimately temporary distortions, inviting risk of longer-term financial instability. The Fed has now done exactly that.
---
The tortured narrative of these efforts should be obvious. As Fred Hickey of the High Tech Strategist observed last week, “After the tech bubble broke, the Fed jumped in to save the markets and economy with a period of extraordinarily low interest rates, which then led to the gross malinvestment in the housing sector (another bubble) and the misallocation of capital in the credit markets. The housing bubble imploded first, and the credit markets followed, leading to one of the worst financial crises in US history in 2008. Once again, the Fed stepped in to save the markets and the economy, this time with really free money (0% short-term interest rates for almost six years and counting) as well as trillions of dollars in outright money printing. Every time the Fed steps in… money gets misallocated and trouble follows.”

Some of the misallocations noted by Hickey include the Fed-enabled runup in the national debt to $17.57 trillion, the surge in global debt issuance to $100 trillion, up from $70 trillion at the mid-2007 peak, the suspension of any need to address unfunded entitlement liabilities, a doubling of the student loan burden, record highs in subprime auto lending, soaring corporate borrowing – partly to buy back stock at inflated valuations (notes Hickey, “as they always tend to do at market tops”) and partly to prop up sagging per-share earnings, a record $465.7 billion in margin debt, more initial public offerings in Q1 than at any point since the 2000 bubble peak, and a litany of other speculative outcomes.

Having witnessed the glorious advancing portion of the uncompleted market cycle since 2009, investors might, perhaps, want to consider how this cycle might end. After long diagonal advances to overvalued speculative peaks, the other side of the mountain is typically not a permanently high plateau. I captured a screenshot on Friday morning, in order to put a timestamp on what may prove – in hindsight – to be a point in history worth remembering.

That said, I should also reiterate that market peaks are not a moment but a process. The bars on the chart above are monthly. If you look carefully, it should be clear that the 2000 and 2007 peaks involved an extended period of volatility that included sharp selloffs, thrilling recoveries, marginal new highs, fresh breakdowns, and sideways movement. All of that day-to-day and week-to-week emotion and uncertainty is absent from a long-term chart where investors know, in hindsight, how utterly insignificant all of it was in the context of what followed.

In 2000 and 2007, we regularly encountered two arguments, which boil down to a) there’s no catalyst, and b) this time is different. In 2000, it was a New Economy. In 2007 and 2008, Ben Bernanke assured investors that the risks were “contained” and Janet Yellen confidently dismissed concerns about speculative risk with the words “No, No, and No.” History suggests a straightforward response: following speculative peaks, market losses are typically in full swing well before any catalyst is widely recognized, and b) the specifics of every cycle may be different, but broadly speaking, speculative episodes end the same way.